Sunday, June 28, 2015

Disclosure is Not Enough: Fiduciaries and the No Conflict Rule

When one is engaged as a fiduciary, the fiduciary steps into
the shoes of the client, in order to act on the client’s behalf. A transfer of
power occurs – if not the actual transfer of assets (as may occur in a trust or
custody relationship), then the transfer of power through the taking, by the
client, of the fiduciary’s advice and counsel (as may occur in a lawyer-client
or investment adviser-client relationship).

The client permits this close, confidential relationship to
exist in recognition that the expertise of the fiduciary, brought to bear for
the benefit of the client, can lead to much more positive outcomes.

But such expertise, if improperly applied, can be used to
take advantage of the client. The fiduciary, as a expert, possess a much
greater knowledge of investments, portfolio management, etc. Also, the client’s
guard is down; due to a variety of behavioral biases, client consent to action
by the fiduciary is easily secured.

Fiduciary law guards against the abuse through its "no conflict" rule.

The No Conflict Rule

In a fiduciary relationship, the law requires that the
fiduciary must not bring her or his own interests into conflict with the
interests of the client. This requirement is called the “no conflict” rule. It
is derived from English law concepts that have flowed into American law from
centuries past.

The “no conflict” rule has nothing to do with good or bad
motive. The U.S. Supreme Court, in discussing conflicts of interest, has said:
‘The reason of the rule inhibiting a party who occupies confidential and
fiduciary relations toward another from assuming antagonistic positions to his
principal in matters involving the subject matter of the trust is sometimes
said to rest in a sound public policy, but it also is justified in a
recognition of the authoritative declaration that no man can serve two masters;
and considering that human nature must be dealt with, the rule does not stop
with actual violations of such trust relations, but includes within its purpose
the removal of any temptation to violate them ....”

And, as the U.S. Supreme Court said a hundred years ago, the
law “acts not on the possibility, that, in some cases the sense of duty may
prevail over the motive of self-interest, but it provides against the
probability in many cases, and the danger in all cases, that the dictates of
self-interest will exercise a predominant influence, and supersede that of
duty.”

Or, as an eloquent Tennessee jurist put it before the Civil
War, the doctrine “has its foundation, not so much in the commission of actual
fraud, but in that profound knowledge of the human heart which dictated that
hallowed petition, “Lead us not into temptation, but deliver us from evil,” and
that caused the announcement of the infallible truth, that “a man cannot serve
two masters.”

Can Client Consent
Occur? Only After Five Steps

In arms-length relationship consent by a customer to
proceed, when a conflict of interest is present, is generally permitted. Caveat emptor (“let the buyer beware”)
applies to such merchandiser-customer relationships. The customer is not represented by the merchandiser but is rather in
an adverse relationship - that of seller and purchaser.

In such instances, it is a
fundamental principle of the common law that volenti non fit injuria – to one who is willing, no wrong is done.
Customer consent to the transaction generally gives rise to estoppel – i.e., the customer cannot later
state the he or she can escape from the transaction because a conflict of
interest was present, or because full awareness of the ramifications of the
conflict of interest were absent. The customer, in such instances, bears the duty of negotiating and effecting a fair bargain. The law permits customers, in such instances, to enter into "dumb bargains."

But the fiduciary relationship is altogether different.
Trust has been given, by the client, to the fiduciary. In such a relationship of trust and confidence, the
law guards against the fiduciary taking advantage of such trust.

Hence, mere consent by a client in writing to a breach of
the fiduciary obligation is not, in itself, sufficient to create waiver or estoppel. If
this were the case, fiduciary obligations – even core obligations of the
fiduciary – would be easily subject to waiver. Instead, to create an estoppel
situation, preventing the client from later challenging the validity of the transaction which occurred, the fiduciary is required to undertake a series of steps:

First, disclosure of all material facts to the client must
occur. For some commentators on the fiduciary obligations of investment
advisers, this is all that is required. Often this erroneous conclusion is
derived from misinterpretations of the landmark decision of SEC v. Capital Gains Research Bureau.

Second, the disclosure must be affirmatively made and timely
undertaken. In a fiduciary relationship, the client’s “duty of inquiry” and the
client’s “duty to read” are limited; the burden of ensuring disclosure is
received is largely borne by the fiduciary. Disclosure must also occur in advance
of the contemplated transaction; receipt of a prospectus following a
transaction is insufficient.

Third, the disclosure must lead to the client’s
understanding – and the fiduciary must be aware of the client’s capacity to
understand, and match the extent and form of the disclosure to the client’s
knowledge base and cognitive abilities.

Fourth, the informed consent of the client must be
affirmatively secured. Silence must not occur. Consent is not obtained through
coercion nor sales pressure.(and
silence is not consent).

Fifth, at all times, the transaction must be substantively
fair to the client. If an alternative exists which would result in a more
favorable outcome to the client, this would be a material fact which would be
required to be disclosed, and a client who truly understands the situation
would likely never gratuitously make a gift to the advisor where the client
would be, in essence, harmed.

These requirements of the common law – derived from judicial decisions over
hundreds of years – have found their way into our statutes. For example, ERISA’s
exclusive benefit rule unyieldingly commands employee benefit plan fiduciaries
to discharge their duties with respect to a plan solely in the interest of the
plan’s participants and for the exclusive purpose of providing benefits to them
and their beneficiaries. And the Investment Advisers Act of 1940 was widely
known to impose fiduciary duties upon investment advisers from its very
inception, and it contains an important provision that prevents waiver by the
client of the investment adviser’s duties to that client.

Disclosure, Alone, Is
Neither a Duty Nor a Cure

It must be understood that there exists no fiduciary duty of disclosure. While
disclosure may be imposed by other law or regulation, or by contractual
obligations created between the parties, disclosure is not, itself, a core
fiduciary obligation.

Rather, fiduciaries owe the obligation to their client to
not be in a position where there is a substantial possibility of conflict
between self-interest and duty. Fiduciaries also possess the obligation not to
derive unauthorized profits from the fiduciary position. This is called the “no
profit” rule, also derived from English law.

While there is no fiduciary duty of disclosure, questions of
disclosure are often central in the jurisprudence discussing fiduciary law, as
many cases involve claims for breach of the fiduciary duty due to the presence
of a conflict of interest. In essence, a breach of fiduciary obligation –
either the obligation not to be in a position of conflict of interest and the
duty to not make unauthorized profits – may be averted or cured by the informed
consent of the client (provided all material information is disclosed to the
client, the adviser reasonably expects client understanding to result given all
of the facts and circumstances, the informed consent of the client is
affirmatively secured, and the transaction remains in all circumstances
substantially fair to the client).

In essence, asking a client to consent to a conflict of
interest by the fiduciary is requesting that the client waive the no conflict
rule and/or the no profit rule generally applicable to fiduciaries. Again,
clients would only do so in circumstances where the client is not harmed.

Hence, disclosure, alone, is not a cure. And disclosure is
only one of the five important requirements, all of which must be met, for a client’s
waiver of a fiduciary obligation to be valid.

The Importance of the No Conflict Rule

As the debate over the imposition of fiduciary obligations upon those providing advice to retirement plan sponsors, retirement plan participants, IRA account holders, and more broadly to any American receiving personalized investment advice, let us first understand that the fiduciary's obligation includes, at its core, the obligation to not put herself or himself into a situation which is in conflict with the client. And, since some conflicts of interest are unavoidable, when such conflicts do occur a series of five important requirements must be met to properly manage the conflict.

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About the Author

Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice.